Using a daily time series from 1983 to 2005 of currency prices in spot and forward USD/Yen markets and matching equivalent maturity short-term US and Japanese interest rates, we investigate the sensitivity of the difference between actual prices in forward markets to those calculated from differentials in short-term interest rates. According to a fundamental theorem in financial economics termed covered interest parity (CIP), the actual and estimated prices should be identical once transaction and other costs are accommodated. The paper presents three important findings: first, we find evidence of considerable variation in CIP deviations from equilibrium; second, these deviations have diminished significantly and by 2000 have been almost eliminated; third, an analysis of the CIP deviations using the local Hurst exponent finds episodes of time-varying dependence over the various sample periods, which appear to be linked to episodes of dollar decline/Yen appreciation, or vice versa. The finding of temporal long-term dependence in CIP deviations is consistent with recent evidence of temporal long-term dependence in the returns of currency, stock and commodity markets.
|Number of pages||13|
|Journal||Physica A: Statistical Mechanics and its Applications|
|Publication status||Published - 15 Mar 2007|
- Covered interest parity
- Efficient market hypothesis
- Hurst exponent
- Temporal long-term dependence